In 2022, despite being an atypical, complex year where the alignment of several factors changed or corrected the dynamics of Venture Capital, it is still the second year of the highest investment for Latin America.
What should we expect in 2023? Phylo Legal and Pygma have joined forces to build this blog post where we consult different sources and opinions from relevant actors in the ecosystem to deliver our perspective on what 2023 will be like for the startup and Venture Capital ecosystem.
According to the State of Venture Report by CB Insights, as of the third quarter of the year, there were $7.9B in investments in Latin American startups. With a total of 1,019 transactions made, during the last quarter, the trend was downward, as investors remained cautious during the last quarter, especially in startups in a Series B or + round stage.
75% of the investment during 2022 has been concentrated in early stages, so without a doubt early-stage startups are the least affected compared to late-stage startups.
However, if we compare 2022 with 2021, we are facing a 62% decrease in Venture Capital investments, this makes us think if we are facing a period of crisis or rather a market correction after an unexpected year, where the dynamics of raising risk capital became unpredictable.
We are facing a market correction due to international conflicts such as the war between Russia and Ukraine. Pressures have increased and put large producers of different resources at risk, and have generated tensions that have made the economic recovery even more complex.
Interest rates due to inflationary pressures have resulted in money becoming more expensive, therefore investors decided to move their assets to more traditional, less risky assets such as Venture Capital. Fall in markets, technology stocks have collapsed to lows not seen in decades, causing paralysis in markets and uncertainty about the future.
Deceleration, valuations are now adjusting and Venture Capital funds are now more careful in the startups they invest in, prioritizing profitability over other factors.
Startups taking care of their runway, which has resulted in waves of mass layoffs from various technology companies that are trying to defend their monstrous valuations and increase their survival by reducing cash burn globally.
We are still quite optimistic in Latin America, one of the biggest advantages of founders is that they are solving structural and big problems, which makes it a big differential compared to other economies. Inflationary pressure, and exchange rate pressure, among others, generate some anxiety, but undoubtedly our thesis has not changed.
We are looking for the founder to understand what stage they are in, and also to understand what stage the funds they are looking for interaction are in, to avoid re-processes, understand the context of valuations and have a relationship with the stage, the economics of the business becomes key.
We are prioritizing having good angels in the cap table, smart money, who can help in strategy, fundraising, and business, we are always bullish with angels, but due to the situation, we are convinced that angel investors will take on a lot of importance
The founder at increasingly earlier stages must test the effectiveness he has in relation to the execution, the moment when money to hide errors worked, is over. Good teams will always find funding, but the fundraising process will be longer and due diligence processes will also be more meticulous, we have to optimize cashflow for that between rounds.
"The 2023 outlook demands a lot of attention in how early-stage companies want to grow and how they project themselves in the medium term. With a historically high-interest rate in emerging countries in Latin America, rampant inflation, and devaluation playing a third adverse factor for economies, we will enter unknown playing fields for most.
We have seen in unicorns, a traditional model promoted by ex-Silicon Valley, that involves growth at all costs, and only works in "bullish" markets. There are moments in the economy when growth at all costs is not useful, as access to capital is very limited. Entrepreneurs have to be prepared to become another type of animal, one that is far from mythical, seen only in deserts, and is an expert in walking long, hot and dry paths: camels”.
“Even though the current context is a bearish market, it is important to remember that VC, as an asset class, is focused on long-term returns. And there will always be opportunities for exceptional founders"
That's why it's a good time to be a founder in the super early stage, this is pre-seed, even up to Series A. Because it gives room for a market correction in terms of valuation towards a more bullish market, which is attractive to investors. Also, by starting a business in a market where capital is more expensive, it is possible that these companies will grow with healthier and sustainable fundamentals and unit economics. Nevertheless, it is a market of investors and more demanding due diligence processes will be seen.
Similarly, product-market fit measurements will be more detailed, and it is expected that the cost of acquiring users will be more efficient; in this sense, it remains to be seen how this affects companies that are raising their Series A this year. For the latter, it may be tight.
On the other hand, startups that are in more advanced stages could leverage their growth in capital markets where money was at very low prices, so growth at all costs was prioritized. Adjustments have already been seen in their models toward path-to-profitability strategies.
On the startup fundraising side, Series B and beyond face huge challenges, first because they need larger tickets to sustain their growth and come from valuations that are being corrected, making them not very attractive deals for VC investors who are betting on multiplying their investment 10x.
Being in stages closer to the possibility of making exits, exit opportunities have a high probability of being impacted by market corrections, generating uncertainty in the measurement of the return of investors.
First let's clarify what a down round is, this occurs when a startup raises a round at a certain valuation and then, in the next round, is forced to raise more resources because its runway has ended, but this time at a lower valuation.
For example, the startup ACME raised US$100,000 from investor Tupac at a valuation of US$1M but then has to raise another US$100,000 from investor Shakur at a valuation of $500,000. What happens? Tupac has 10% of the company which cost him US$100,000, while Shakur has 20% which cost him US$100,000.
This is a type of dilution that is not a percentage for Shakur, since he still has his 10% (theoretically without taking into account the share dilution that the entry of Shakur implies). But it is an economic dilution of the value of the asset, since his 10% is now worth half of what it originally cost.
Faced with these situations, it is possible that investors like Tupac have managed these risks with anti-dilution protections, contained in shareholders' agreements or other documents, under which they should be compensated and maintain their participation/perceived value, through the delivery of more shares probably from the founder's pocket (who must take care of his position in the cap table to keep it investable) so it is not at all advisable this scenario.
So it is possible that we will see several down rounds because the founder is basically facing several questions:
Mass layoffs allow for the relocation of large talents, who then create companies and create huge value for early-stage startups that manage to attract them with options such as vesting.
History favours difficult times as a point of genesis for big companies. In the 2000 crisis Amazon, Wikipedia, and eBay were founded. In 2008, Airbnb, Uber, and Privalia.
Just getting through these turbulent times will create rigor and austerity in entrepreneurs that will create sustainable companies and when liquidity returns to the market, they will have solid foundations to scale.
In the end, if you can't get external investors, you have one last resource that big companies like MailChimp used and ended up worth billions of dollars and it's called bootstrapping. It simply consists of not raising capital and creating a company with what you generate.
Especially in post-series A rounds, an excessive blow has been seen in the value of growth-stage companies, that have had to resort to closing their doors, raising rounds in unfavourable situations such as "down-rounds" and have been hit with waves of criticism.
There will be new players who maybe hadn't ventured before due to a lack of business fundamentals and justifications for valuations. Doors that were previously closed for unsophisticated angels will open since many entrepreneurs will seek to extend their runway with "bridge rounds" which will create spaces for investors who suddenly wouldn't have been able to enter these rounds.
This an important message to leave to the community, it is very easy to criticize from the outside, but few of us know the difficult and unpredictable reality of creating and scaling a startup. In some cases, the nature of investment funds can distort valuations to accommodate spaces in shareholder compositions.
We believe that this is not about looking for blame, as the entrepreneur "over-hired" it can be said that the investor "over-invested" or "didn't do the homework". This is about learning from what has been experienced and keeping the good, the bad, and the regular.
The message remains the same, this is a young ecosystem that requires constant support from all who are part of it and we will continue to look for ways to connect the dots and leave our mark on the region from Pygma.
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